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Staples - Q1 in the Books, A Look Back

"May you live in interesting times."

 

-Reputed Chinese curse

 

It has been an interesting start to the year, to say the least, for the consumer staples sector.  The sector's leadership status in a strong tape is certainly an unfamiliar and perhaps uncomfortable position for many investors.

 

In review, another month in the books and another month of out-performance for our coverage.  On average, consumer staples stocks rose 4.8% in March, with only the household and personal care sector and the tobacco sector lagging the S&P's +3.6% rise during the month.

 

Staples - Q1 in the Books, A Look Back - Sector Performance 3.29.13

 

Staples - Q1 in the Books, A Look Back - Consumer Staples ETF  corrected

 

Packaged food continued its strong performance (+7.0% in March) in the wake of the Heinz transaction, lagging only the protein sector (+9.0%) in terms of monthly performance.

 

We continue to struggle (based on our conversations with clients it seems many dedicated staples investors share the sentiment) with valuation.  However, we recognize that valuation in and of itself is not a catalyst and that valuation may not matter for periods of time, perhaps extended periods of time.  The simple fact is that a number of staples names have outstripped the multiple that we are comfortable paying for the cash flow stream, even considering earnings upside from potential margin improvement driven by lower commodity costs and improvements in business momentum driven by improved consumption trends.  That doesn't mean that we are in a hurry to run out and short everything, but we caution investors to recognize that at some point, valuation will matter.

 

Staples - Q1 in the Books, A Look Back - Consumer Staples Forward PE 3.29.13

 

Staples - Q1 in the Books, A Look Back - Packaged Food Relative PE

 

This month we have added a look at several quantitative factors in relation to the staples sector.  Keep in mind that all these factors are relative within staples (i.e. smaller capitalization does not meet the technical definition of small cap, but rather represents a name within the lower half of the cap spectrum within staples).


Staples - Q1 in the Books, A Look Back - Beta Chase 3.3.29

 

Staples - Q1 in the Books, A Look Back - Debt to EBITDA

 

Staples - Q1 in the Books, A Look Back - Quant Factors   Dividend Yield

 

Staples - Q1 in the Books, A Look Back - Quant Factors   Market Cap

 

Staples - Q1 in the Books, A Look Back - Quant Factors   Short Interest

 

Based on the above analysis, we can develop several themes in terms of what has worked within the staples sector:

  1. In March, lower beta (lower growth, perhaps 2012 laggard) outperformed higher beta names
  2. Higher short interest has been a consistent out-performer in 2013
  3. Smaller capitalization names had a very good month in March
  4. Dividend yield doesn't tell us much of a story - lower yield had a period of out-performance that has since reversed
  5. Higher debt to EBITDA has been a consistent outperformer, likely representing outperformance of lower "quality" names

Bear in mind, the performance of the staples sector has largely been absent any significant, positive EPS revisions.  Further, absent any material change in business momentum or margins, consensus estimates should head lower on the strength of the dollar to the extent a company has businesses outside the U.S.  While we acknowledge the impact of translating a set of results from one currency to the next is largely irrelevant to the value of a business, optics do matter.

 

Staples - Q1 in the Books, A Look Back - EPS Revision Chart

 

Revisiting an analysis from last month, we see that performance was balanced across PE quartiles, with the modest relative under-performance in higher multiple names largely caused by BNNY's monthly performance (-9.5%).  In fact, it was nearly impossible to find a consumer staples stock that didn't go up in the month of March.

 

Staples - Q1 in the Books, A Look Back - Monthly Performance by Quartile 3.30.13

 

Similar to last month, multiples expanded across all quartiles.

 

Staples - Q1 in the Books, A Look Back - PE by Quartile 3.30.13

 

In keeping with a familiar theme, the yield spread between the 10 year treasury and the XLP has widened in recent days, making the XLP marginally more attractive to investors seeking yield.  Further, we think it is possible that yield bearing assets in the U.S. (XLP and consumer staples stocks included) might see inflows to the extent that confidence in the European banks has taken a hit in the wake of the Cyprus situation.

 

Staples - Q1 in the Books, A Look Back - XLP vs. 10 year 3.30.13

 

Staples - Q1 in the Books, A Look Back - Yield Spread 3.30.13

 

Finally, taking a look at the performance of the XLP in relation to a basket of economic indicators and the performance versus consensus shows us that the broader economy continues to surprise to the upside (consistent with Hedgeye's macro call) driving performance of the XLP.

 

Staples - Q1 in the Books, A Look Back - XLP and economic surprises  corrected

 

Staples - Q1 in the Books, A Look Back - Economic Surprise Index

 

 

Where does that leave us?

 

Valuations suggest that we should stick to the sidelines, but it is difficult to ignore/fight improvements in the economy and money flows.  Therefore, we are going to stick with value where we can find it and our preferred list remains unchanged:

  1. ADM
  2. BUD
  3. CAG
  4. NWL

Our least preferred list could be much longer based solely upon our concerns surrounding valuations in the sector, but for the moment we will add two names as we approach Q1 EPS:

 

  1. KMB
  2. GIS
  3. TAP
  4. CL (new)
  5. K (new)

Enjoy the rest of your weekend.

 

Rob

 

Robert  Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

E:

P:

 

Matt Hedrick

Senior Analyst


THE WEEK AHEAD

The Economic Data calendar for the week of the 1st of April through the 5th is full of critical releases and events. Attached below is a snapshot of some (though far from all of the headline numbers that we will be focused on.

 

THE WEEK AHEAD - WeekAhead


Investing Ideas Newsletter

Editor’s Note: Welcome to the inaugural edition of the Investing Ideas weekly newsletter, which replaces our Weekly Hot Ideas newsletter. Each week, you’ll get a summary of our top Investing Ideas, a detailed Macro Update on key events that shaped the week, a Sector Spotlight, which focuses on a key industry or industries every week plus an Investing Term of the Week, where we’ll demystify the jargon and clearly explain a popular investing term.

 

Additionally, you will have access to Stock Reports, which are one page reports on the individual stocks that make up our top Investing Ideas. To find those, just log in to the web site, go to the Dashboard, and click on the Investing Ideas tab on the left side of your screen. Then, you’ll see a list of all Stock Reports plus a list of all the most recent Investing Ideas weekly newsletters.

 

Now, please enjoy the inaugural newsletter below. If you do have questions, please email us at .

Macro Update: A Refrigerator in Every Kitchen

Hedgeye’s fundamental view of accelerating economic activity in the US was bolstered this week as US Macro analyst Christian Drake called out key economic reports in Durable Goods Orders (up 5.7% month-over-month) and existing home prices (up 8.1% year-over-year). 

 

Durable goods, or big ticket items like refrigerators, furniture or cars, and rising home sales point to a stronger economy and a potentially a stronger consumer.

 

February’s Durable Goods increase came on top of an upward revision of January’s figures and flipping from negative to a strong positive reading.  While there may be unevenness as the Sequester disrupts such industrial goods as defense-related aircraft, Drake says positive growth trends in capital goods and consumer durables continue to look positive, providing impetus for business investment.

 

Meanwhile, existing home prices continue to move ahead, driven by that old economic saw The Law Of Supply And Demand.  As Health Care sector head Tobin’s work on birth rates and new household formation shows, there is definite increasing demand. 

 

And as Financials sector head Josh Steiner has reported, there is a tightening supply: builders downsized capacity in the heart of the financial crisis and will take time to ramp up.  This is also because the decline in building activity reverberated downstream: building materials and supplies, and the machinery and equipment for new construction all downsized as their customers shrank their operations.  It will take time to rebuild this entire supply chain. 

 

Meanwhile, without the capacity to build new houses fast enough to satisfy current demand, the demand for existing homes should continue higher.  Drake reminds us that Hedgeye views housing as a Giffen Good, the economic anomaly where higher prices cause higher demand, rather than scaring away consumers.  Thus the current increases in the Case Schiller housing price index should attract still more demand – which will further tighten the supply – which will push up the price – which will drive demand still higher... so stay tuned.

 

Sector Spotlight: Restaurants and Consumer Staples

The upsurge in housing, combined with increased buying in consumer durables, points to accelerated household formation.  This is further bolstered by ahead-of-the-curve work by our Health Care team that indicates a climb in birthrates.  Recovery in buying patterns is driven as much by confidence in the future as by actual cash in the bank. 

 

Buying patterns look set to recover as America wakes up to the reality of a recovering economy.  At a certain point, consumers start buying in anticipation of their next paycheck.  Increasingly positive macro data bodes well for consumer-driven companies, as highlighted by recent work from our Restaurants sector head, Howard Penney, and our Consumer Staples sector head, Rob Campagnino.

 

Restaurants – Penney’s latest work indicates that a strong macro picture should start to fill in the blanks at Burger King (BKW).  Penney had a short call on the company until last week when the surge in macro data, combined with a strong emerging quantitative set-up for BKW stock, overshadow his bear case.  Following on the heels of that switch, Penney went bullish on Darden Restaurants (DRI), which was added as a an Investing Idea on March 11. 

 

Key to Penney’s call on DRI is his sum-of-the-parts analysis, which he says puts a much higher value on the company than reflected in the current stock price.  Penney also sees indications of emerging pressure for strategic changes at the company, whether from significant outside investors, or even from within the board of directors.

 

Consumer Staples: Campagnino points to a number of factors in favor of his sector today.  The obvious ones include all the points we referenced above – the acquisition of more refrigerators as more new households are formed is clearly good for business in the sector. 

 

But Campagnino says the sector has not yet clearly mirrored the behavior in other sectors, where larger-capitalization companies draw more investment dollars.  Campagnino interprets this as investors such as big mutual funds, who have to put their money into stocks, looking for low-beta ways to participate in a market rally they still don’t completely believe in.  He believes there are key stocks in the sector that will continue to surprise to the upside, such as ConAgra Foods (CAG), which we added as an Investing Idea on February 11.

 

Campagnino likes CAG’s recent acquisition of Ralcorp, the leading private-label foods manufacturer.  This makes the new CAG the largest private branded food company in the US, and the private label business is growing twice as fast as CAG’s basic branded business. 

 

Campagnino says “deal stocks” tend to do better in his sector, and as more details of the Ralcorp acquisition are understood, the stock can continue higher.  For example, he thinks the combined entities will generate synergies in excess of the predicted $225 million. 

 

And while Hedgeye’s Macro work indicates the “US Dollar up / Global Commodities down” relationship may not be as direct as it once was, Campagnino says any weakness in foodstuff commodities can flow right through to CAG’s income statement. 

 

Finally, Campagnino likes the visibility of a big stock, with a good story, making new highs.  Many investors naturally shy away from buying stocks at their highs.  But ask yourself, Where will selling pressure come from?  After all, at an all-time high in a stock, where are the unhappy shareholders?

 

Investment Term: Equal-Weighted Index

We are all familiar with the concept of portfolio diversification.  In its simplest form, a diversified portfolio of different companies, spread across several industry groups, provides a built-in hedge: when one sector is weak, other sectors are likely to be strong. 

 

The likelihood of all the stocks in your portfolio dropping in price at the same time is low.  And if they all drop in value, it’s likely because you are in a bear market.  In which case, as your portfolio manager will tell you, “All bets are off.”

 

The Standard & Poor’s 500, one of the best-known market benchmarks, contains the 500 leading companies traded in the US.  Moves in the S&P 500 index during the trading day reflect changes in the prices of those 500 companies, weighted to reflect their importance in the market.  The bigger a company’s market capitalization, the greater its weighting in the index. 

 

Academic research based on Modern Portfolio Theory (MPT) says the best way to achieve diversification is to own a portfolio that mirrors the broad market – and MPT argues that capitalization-weighting is the proper way to go.

 

Hedgeye’s domestic US Macro analyst Christian Drake provides a chart that challenges MPT and implies that weighted diversification may be measurably inefficient.  If you are an index fund investor, you may be able to improve your investment performance by readjusting the weightings in your portfolio. 

 

In addition to the standard index-tracking funds, there are also ‘equal-weight” funds and ETFs available, which invest in the same stocks as the standard index funds, but with equal weightings.

 

An S&P 500 index fund is structured to mirror the performance of the index.  This means each stock holding in the fund will be given the same weighting as that stock represents in the index.  In an equal-weight fund, each stock is weighted the same as all others.  Each stock in an equal-weight S&P 500 fund represents exactly 1/500th of the portfolio, regardless of its weighting in the reported S&P index.

 

One study found an equal-weighted S&P 500 ETF outperformed its traditional sibling by about 1.5% annually, and did it rather consistently.  While one study does not an investment philosophy make, Drake’s chart indicates that equal-weighted vehicles should behave very differently from their traditional namesakes and may provide superior performance over the longer term.



investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.

Still Bullish: SP500 Levels, Refreshed

Takeaway: Embrace crisis – the real crisis appears to be in crisis-calling itself.

This note was originally published March 28, 2013 at 10:59 in Macro

POSITIONS: 14 LONGS, 7 SHORTS @Hedgeye

 

The all-time closing highs have been elusive, but that just gives Professional Top Callers (PTCs) more company. I can’t count how many people are trying to call the top at this point (and I can count).

 

The fulcrum point of our bull case on US Growth (#StrongDollar) remains not only intact, but improving by the week. This is the 7th week in the last 8 that the US Dollar Index is up wk-over-wk. And combined with both US employment and housing trends, we think that’s a pro-growth signal.

 

Across our core risk management durations, here are the lines that matter to me most:

 

  1. Immediate-term TRADE overbought = 1569
  2. Immediate-term TRADE support = 1555
  3. Intermediate-term TREND support = 1494

 

In other words, both the US Dollar and the US Stock Market remain in what we call Bullish Formations (bullish TRADE, TREND, and TAIL) as our immediate-term Risk Range continues to signal higher-lows and higher-highs for the SP500.

 

Don’t buy at the overbought line. Buy them when they are red. Embrace crisis – the real crisis appears to be in crisis-calling itself.

 

Have a Happy Easter Weekend,

Keith

 

 

Still Bullish: SP500 Levels, Refreshed - MyChart


MACAU: COMMISSIONS TICK UP IN Q4

Macau has appeared bullet proof but one chink in the armor is emerging

 

 

COMMISSION RATES RISING

Since bottoming in 1H 2011, the all-in commission rate paid by operators for VIP business has once again risen.  Viewed as a % of win or as a % of RC, the conclusion is the same.  The chart below shows 3 straight periods of higher commission rates.

 

MACAU: COMMISSIONS TICK UP IN Q4 - m5

 

RATE TIED TO VIP GROWTH

The rebate and comp portion of the all-in commission are contra-revenue items that reduce gross revenue.  The junket commission impacts margins as it is a direct expense out of net revenues.  Obviously, rising commissions are not a positive for the market and show how competitive the VIP segment has become.  It will be interesting to see how commissions fare in 1H 2013 as VIP is undergoing somewhat of a resurgence, particularly here in March.  As one can see from the following chart, commission rates tend to rise when VIP volume slows.

 

MACAU: COMMISSIONS TICK UP IN Q4 - M777

 

COMMISSION ANALYSIS BY COMPANY

 

The chart below shows the composition, by company, of all-in commissions among the straight junket commission, the rebate that goes back to the player, and non-gaming giveaways, all on a revenue share basis.  

 

MACAU: COMMISSIONS TICK UP IN Q4 - m7777

 

Takeaways: 

  • Rebates and comp’d non-gaming revenues are continuing to increase when measured as a % of RC and as a % of win while junket commissions actually declined on both a YoY and 2H12 vs. 1H12 basis.  Part of the uptick that we are seeing in rebates and comps is likely driven by higher comps given to premium mass as that segment grows.  While we know what rebates and comps are, we do not know how much of them go back to mass players.
  • WYNN remains the least aggressive in its commission policy.  From 2008 to 1H11, the spread between the average all-in commission rate paid by WYNN vs. average of LVS, MPEL & MGM narrowed from 7.57% to 2.85%.  In 2012 it gapped out again to 4.14% and to 4.69% in 2H12. 
  • MGM took first place for offering the largest junket commissions in 2H12 at 8.9% (as a % of win) or 26bps (as a % of RC), ahead of MPEL which was formerly the most aggressive.
  • Rebate rates
    • The average rebate rate in 2H12 increased to 33.9% (as a % of win) or 100bps (as a % of RC) vs. 32.4%/96bps in 2H11
    • WYNN had the lowest rebate rate in 2H12 at 30.7%/93bps
    • MGM had the highest rebate rate in 2H12 at 38.2%/111bps
  • Junket commission  
    • The average junket commission decreased 6% in 2H12 vs 2H11 on a % win basis, and 7% on a RC basis to 8.0%/23bps, respectively
    • Wynn continued to offer the lowest commission rate of 7.2%/22bps
    • MGM took the lead on offering the highest commission rate of 8.9%/26bps
  • Comped non-gaming amenities
    • The average non-gaming comps increased 12% YoY in 2H12 vs 2H11 to 4.9% as a % of win and to 14bps as a % of RC
    • MGM offered the lowest comps at a rate of 3.5%/10bps
    • LVS continued to offer the highest comps at a rate of 6.7%/20bps, which is not surprising given that they have the largest % of their revenue base coming from non-gaming amenities.  
  • The all-in commission rate
    • The average all-in commission rate increased to 46.7% in 2H12 from 45.4% in 1H12 on a % of win basis and from 1.34% to 1.37% on a RC basis
    • MGM paid the highest all-in rate at 50.6% or 1.47% in 2H12
    • Wynn held the line at 43.2%/1.31% in 2H12

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS?

Takeaway: Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.

SUMMARY BULLETS:

 

  • We believe that China has a fair amount of systemic risk built up across its financial sector; in the note below, we walk through the key risks, potentially adverse outcomes and how Chinese officials have responded to them in previous iterations, as well as how they may respond to them in the future. It should be noted that the aforementioned risks are reasonably offset by the political will and fiscal firepower needed to avoid a systemic collapse.
  • As we penned in our 3/13 note titled, “CHINA’S IN NO MAN’S LAND”, the fundamental outlook for both the Chinese economy and the Chinese equity market is now particularly uncertain – especially in light of the risks embedded in China’s shadow banking market. In confusing times like these – particularly when the data is either sparse or misleading – we defer to our quantitative risk management signals for guidance. On that note:
  • BUY [more] on a breakout above TRADE resistance (2,298): A probable sequential pickup in MAR growth data and a probable sequential slowing in MAR inflation data supports this action. Moreover, continued USD strength (and, by association, CNY strength) should weigh on int’l raw materials prices and allow the pace of economic activity to creep higher in China, as China’s heavy industry needs energy and raw material deflation to produce more with less credit expansion and the Chinese consumer needs food deflation to consume more discretionary goods and services.
  • SELL on a breakdown through TAIL support (2,306); SHORT China on a breakdown through TREND support (2,206): As we’ve seen since 2009, the pace of activity in the Chinese property market has become the #1 factor in determining growth rate of Chinese economy – via credit expansion – and the returns of Chinese financial markets. That quantitative signal would be a clear-cut sign that there is likely more policy-perpetuated pain to come in the months ahead – especially to the extent those linkages have not broken down as much as the CCP would’ve liked.
  • At any rate, we think it’s best to run full speed away from anyone who tells you they know exactly how this all ends and on what duration(s). China is quite possibly the largest and most unique economy (capital controls, state-capitalism, etc.) ever to have to undergo such meaningful financial reforms. There will be winners (i.e. Chinese consumers and SMEs), losers (i.e. Chinese property developers and marginal producers in oversupplied industries) and [many] unintended consequences that are, quite frankly, hard for even the best industry analysts to accurately predict at the current juncture.

 

THE RISKS

Earlier this week China Daily reported that the China's banking regulator has urged banks to pay close attention to the credit risks in key industries affected by the economic downturn and hit by overcapacity woes. Zhang Ping, Chairman of the National Development and Reform Commission recently said that the industrial sectors suffering most from overcapacity include steel, cement, electrolytic aluminum, plate glass and coal coke sectors, each of which is operating at 70-75% of total capacity.

 

The aforementioned article also showed that analysts estimate the outstanding loan portfolio of those industries may amount to around 30T-40T yuan ($4.83T-$6.44T or 22.6-30.2% of total banking system assets at the end of JAN). Per the PBOC, outstanding loans to the property sector were 12.1T yuan at EOY ’12.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 1

 

In addition to these on-balance sheet risks, China has roughly 15T yuan of off-balance sheet credit (28.8% of GDP) in the form of commercial bills, trust financing, entrusted loans, etc. that has increasingly been allocated to riskier borrowers in recent years (per various agencies, including the IMF) – many of whom which have outsized exposure to property prices, such as property developers and local gov’t financing vehicles (LGFVs).

 

It’s worth noting that residential and commercial land prices did rise +2.3% YoY and +3.3% YoY, respectively, in 2012 and that Chinese real estate prices are increasing in multiples of those growth rates in recent months.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 13

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 14

 

The latter entity has 636.8B yuan in bonds outstanding as of EOY ’12 (+148% YoY) and 9.3T yuan of loans outstanding (17.9% of GDP) – 20% of which are “funding projects which are largely not profitable and thus are vulnerable to [repayment] risk,” per PBOC Governor Zhou Xiaochuan. Want China Times suggests as much as 53% of LGFV debt is set to mature in 2013, though it is widely expected that the bulk of loans facing repayment risk will continue to be rolled over. Liquidity delays insolvency.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 2

 

To the previous point regarding the growing exposure of China’s financial system to the country’s property market – which remains structurally underpinned by the confluence of financial repression and a closed capital account – both Chinese banks and large cities (Guangdong, Shenzhen) have recently begun to implement the latest round of nationwide property curbs, which, as we penned on 3/1, were more severe and announced far sooner than we had anticipated.

 

HISTORICAL PRECEDENT

While we’re not in the camp that believes China’s financial system is careening towards crisis, we’d be remiss to ignore the risks associated with rapid credit expansion coupled with an increasing overreliance upon pooled capital largely feeding into collateralized property market exposure. If this sounds familiar, it should; the major difference between the US and Chinese experiences, however, is that Chinese officials are well aware of these risks ahead of time and continue to implement a series of macroprudential measures designed to mitigate them in a proactive manner (vs. being fast asleep at the wheel like Greenspan and Bernanke were).  

 

From a corporate perspective, Bloomberg data shows the average debt/EBITDA ratio of Chinese non-financial corporations has nearly doubled to 4.1x from 2.2x over the last five years. Per Liu Yuhi, Director of the Financial Lab at the Chinese Academy of Social Sciences: “Although financing activities in the country appear to be rampant, most of the newly borrowed money is used to repay debts instead of forming revenue among companies.” The value of LGFV loans that matured last year was 1.9T yuan, with about 86.7% repaid on time.

 

Indeed, a great deal of recent credit expansion has been simply to roll over existing loans and, while that mitigates the risk of a potentially-destabilizing near-term acceleration in NPLs, it does come at the direct expense of Chinese economic growth – which we have contended and continue to believe will remain rather subdued relative to prior cycles (see: 13-straight weeks of steel product inventory increases as of MAR 10th).

 

SHORT-CYCLE OUTLOOK

It’s a reasonable assumption that China’s fixed asset investment-driven economy (China’s “I”/GDP ratio is roughly 1,000bps too high per the IMF) may indeed experience a major financial shock followed by a prolonged economic downturn when it’s all said and done. That said, however, as long as the CNY continues to make a series of higher-highs on a ~19 year basis and the SHCOMP remains in a Bullish Formation, we think it pays to ignore those risks for now and bet on a continued cyclical upswing in the Chinese stock market(s).

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 3

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 4

 

Because of China’s crawling currency peg, Strong Dollar = Strong CNY (for the most part, absent heavy PBOC intervention) and that ultimately equates to declining CPI and PPI figures on a lag (see: yesterday’s preannounced gasoline and diesel price cuts of CNY 0.23 per liter and CNY 0.26 per liter, respectively, and the NDRC’s aggressive denial of a market rumor natural gas prices would be hiked in APR).

 

That should ultimately equate to a higher velocity of money in China over the intermediate term, given the State-imposed targets for monetary expansion (2013 M2 Target of +13% YoY, down from +13.8% in 2012; 2013 New Loan target of 9T yuan, up from 8.2T in 2012). CNY strength predicated on inflows of foreign capital (see: latest FDI and Foreign Deposits data, which were up +6.3% YoY and +4.1% YoY, respectively) should help offset the PBOC’s increased hawkishness, at the margin.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 5

 

All told, we still think that the risk is to the upside in Chinese equities over the intermediate-term TREND; refer to the section below titled, “PARTING THOUGHTS” for more details. From a long-term TAIL perspective, the beta risk is truly anyone’s best guess. Elements of systemic risk are indeed present across China’s financial sector – but so is the political will and fiscal firepower needed to avoid a systemic collapse.

 

LONG-TERM OUTLOOK

We’ve come across several analyses that suggest that adding in all “contingent liabilities” would increase China’s sovereign debt/GDP ratio to north of ~90% (vs. an official ratio of 22.2%), thus limiting its ability to respond to any potential financial crisis with fiscal measures. That does, however, compare rather handsomely with our estimate of a ~450-500% ratio for the US gov’t in 2012 when we last completed the analysis back in a late-2010 presentation on the US’s fiscal outlook. Consensus storytelling has a bad habit of ignoring counterfactual evidence.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 6

 

Imagine if the Treasury/Fed didn’t let Bear Sterns or Lehman Bros. fail and the federal balance sheet had enough borrowing capacity to actually afford what many consider to have been largely wasteful “stimulus” measures and “defense” spending. We’d be willing to bet that the last five years of domestic economic conditions would have looked remarkably different relative to the sluggish pace(s) of activity and growth scares we’ve become accustomed to… that’s China’s opportunity in a nutshell.

 

At any rate, timing, as always, will be critical – as will the Politburo’s policy response. Will the Chinese Communist Party be proactive or reactive in dealing with these risks? That remains the key question for investors to consider; and, at these prices, we think it pays to bet on the former – of course pending further data! In the spirit of being proactive, the China Banking Regulatory Commission (CBRC) has assigned “preventing financial risks” as its top priority for 2013.

 

STRUCTURAL CHANGES AHEAD

As it relates to the PBOC’s role in the aforementioned agenda, there was some very important news announced yesterday in the arena of financial market reform. It was reported that new Premier Li Keqiang – among China’s most reformed-minded officials – will pursue incremental reforms in the form of further interest rate and/or exchange rate liberalization in the calendar year 2013.

 

As an aside, we think Li’s reform agenda is one of the primary reasons current PBOC Governor Zhou Xiaochuan retained his role after rounds of speculation that he would be replaced – potentially by Xiao Gang, Chairman of the Bank of China, and now a candidate for the top job at the China Securities Regulatory Commission (CSRC).

 

Under Zhou’s veteran watch, the PBOC may opt to relax or remove the cap on deposit rates, lower the floor on lending rates and/or widen the daily yuan trading band. This would build upon previous reforms in this general direction, as the PBOC, for the first time ever in 2012, permitted deposit rates as high as 110% of the benchmark. It also lowered the lending rate floor to 70% of the benchmark from 90% prior. As an aside, additional interest rate liberalization may put Chinese banks’ NIMs at risk of further compression. Additionally, the current +/- 1% margin around the PBOC’s reference rate was set back in APR ’12. 

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 7

 

INTENDED AND UNINTENDED CONSEQUENCES

The fact that these reforms are going to take place over the intermediate-term TREND vs. long-term TAIL is very, very interesting. On one hand, financial sector reforms will reduce the high burden of financial repression currently being levied upon Chinese households and SMEs, affording them better inflation-adjusted returns on their savings and far greater access to traditional bank credit, which is generally cheaper (in China) and more closely regulated.

 

That would be particularly positive for the expansion of China’s consumer sector and Chinese economic growth more broadly by supporting the Chinese Communist Party’s economic rebalancing agenda by allowing Chinese banks to take more risk via an increased allocation of capital to more productive and profitable enterprises than SOEs, which themselves perpetuate China’s overinvestment due to a systemic overreliance upon subsided credit and other heavily-subsidized factors of production to the tune of ~4% of GDP, per the latest IMF estimates.

 

On the other hand, better returns and improved access to credit for Chinese households and SMEs, respectively, may perpetuate an unwind of off-balance sheet lending activities, which, according to most sources, have been largely capitalized with the savings of China’s private sector that are seeking higher yields via Trust Products and Wealth Management Products (WMPs), where average annualized yields are 37% higher than the PBOC benchmark 1Y household deposit rate of 3%.

 

To the extent there are any weak hands in the WMP or trust financing space, a lack of new inflows, at the margins, would expose the “ponzi-scheme” nature of some products (per the words of the aforementioned Xiao Gang himself) – specifically those that rely on short-term funds in order to invest in long-term assets (including not-yet-profitable infrastructure projects or real estate) and fund distributions largely with net new inflows.

 

Because the bulk of this off-balance sheet lending activity is rather poorly regulated, it’s impossible to know the true size and scope of such at-risk institutions (i.e. any sell-side estimates you may have come across are likely closer to outright guesses rather than semi-accurate guesstimates).

 

China bears would have you believe that these types of at-risk loans comprise 100% of the ~15T yuan of estimated shadow financing; China bulls would have you believe that this type of highly speculative activity is confined to manageable, one-off cases like the city of Wenzhou – where more than 80 businessmen, unable to make payments on underground loans, committed suicide or declared bankruptcy in a six-month period last year.

 

REGULATORY RISK IS REAL

Today, the CBRC announced its first round of truly stringent regulation surrounding commercial bank’s involvement in the WMP market. Specifically, no more than 35% of a bank's WMPs or 4% of a bank’s total assets recorded in the previous fiscal year should be invested in debt that is not within the formal bond market. As an aside, debt outside “formal” bond market refers to credit assets, trust loans, entrusted loans, acceptance bills, letters of credit and account receivables that are not traded on the securities exchange or interbank market.

 

In addition to the aforementioned cap, and perhaps most importantly, the CBRC stated that commercial banks should not provide guarantees or make repurchase commitments to their WMPs. The latter regulation explicitly transfers the burden of repayment risk to depositors – many of whom may already be victims of moral hazard in the sense that they believe the banks will ensure their returns to the extent there are any defaults by the ultimate borrowers of the funds.

 

Currently the amount of banks’ outstanding WMPs stands at 8T yuan. Per the aforementioned cap, commercial banks can invest up to 2.8T yuan via their WMPs in debt outside the formal bond market – which is 1T yuan less than their current exposure!

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 8

 

Ultimately, this rule should translate into slower (and potentially even negative) growth in the supply of credit within the shadow banking channel and to the extent any existing liabilities facing repayment risk aren’t able to be rolled over, we will start to see default rates accelerate across China’s shadow banking sector. Any spillover effects across key industries – particularly in the oversupplied construction and construction materials sectors – could adversely impact Chinese bank NPL ratios (currently at 0.95%) on a lag.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 9

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 10

 

PARTING THOUGHTS

As we penned in our 3/13 note titled, “CHINA’S IN NO MAN’S LAND”, the fundamental outlook for both the Chinese economy and the Chinese equity market is now particularly uncertain – especially in light of the risks embedded in China’s shadow banking market. In confusing times like these – particularly when the data is either sparse or misleading – we defer to our quantitative risk management signals for guidance. On that note:

 

  • BUY [more] on a breakout above TRADE resistance (2,298): A probable sequential pickup in MAR growth data and a probable sequential slowing in MAR inflation data supports this action. Moreover, continued USD strength (and, by association, CNY strength) should weigh on int’l raw materials prices and allow the pace of economic activity to creep higher in China, as China’s heavy industry needs energy and raw material deflation to produce more with less credit expansion and the Chinese consumer needs food deflation to consume more discretionary goods and services.
  • SELL on a breakdown through TAIL support (2,236); SHORT China on a breakdown through TREND support (2,206): As we’ve seen since 2009, the pace of activity in the Chinese property market has become the #1 factor in determining growth rate of Chinese economy – via credit expansion – and the returns of Chinese financial markets. That quantitative signal would be a clear-cut sign that there is likely more policy-perpetuated pain to come in the months ahead – especially to the extent those linkages have not broken down as much as the CCP would’ve liked.

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - 11

 

At any rate, we think it’s best to run full speed away from anyone who tells you they know exactly how this all ends and on what duration(s). China is quite possibly the largest and most unique economy (capital controls, state-capitalism, etc.) ever to have to undergo such meaningful financial reforms. There will be winners (i.e. Chinese consumers and SMEs), losers (i.e. Chinese property developers and marginal producers in oversupplied industries) and [many] unintended consequences that are, quite frankly, hard for even the best industry analysts to accurately predict at the current juncture.

 

Happy Easter; enjoy the long weekend with your respective families.

 

Darius Dale

Senior Analyst

 

IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? - China SHCOMP


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